Eleanor Finch
Individual Retirement Accounts (IRAs) are tax-advantaged plans under the Internal Revenue Code (IRC) that are intended to encourage individuals to save for retirement. The IRC contains a series of prohibited transaction rules intended to prevent the IRA owner from enriching themselves, their family members, or entities in which they retain an interest (disqualified persons). These prohibited transactions are outlined in IRC Section 4975, which imposes penalties on disqualified persons who engage in prohibited transactions. However, certain exceptions, such as investment advice provided as part of an eligible investment advice arrangement, do not constitute prohibited transactions under IRC Section 4975. Understanding these rules is crucial for IRA owners to avoid adverse tax consequences and ensure compliance with the law.
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What You'll Learn
- Sale, exchange, or leasing of property between an IRA and a disqualified person
- Lending of money or extension of credit between an IRA and a disqualified person
- Furnishing of goods, services, or facilities between an IRA and a disqualified person
- Transfer of IRA assets to or use by a disqualified person
- Acts by a fiduciary that involve self-dealing
Sale, exchange, or leasing of property between an IRA and a disqualified person
The IRC Section 4975(c) lists "Prohibited Transactions" as any direct or indirect sale, exchange, or leasing of property between a plan and a disqualified person. This includes the sale or exchange of any property, such as real estate, between an IRA and a disqualified person.
A disqualified person can include the IRA owner's fiduciary and members of their family, such as a spouse, ancestor, lineal descendant, or spouse of a lineal descendant. For example, if an IRA owner sells property owned by their IRA to their son, this would be considered a prohibited transaction under IRC 4975(c)(1)(A). Similarly, leasing real estate owned by an IRA to a family member is also prohibited.
However, it is important to note that the mere formation of a business by an IRA alone or with unrelated or related parties is not typically considered a prohibited transaction. Additionally, if a disqualified person receives any benefit to which they are entitled as a plan participant or beneficiary, such as a participant loan, it is not considered prohibited, as long as the benefit is on the same terms as for all other participants.
The regulations also specify that a transaction between a disqualified person, such as an "S" corporation, and an IRA, where the IRA's assets are not considered plan assets, is generally not prohibited. However, if the IRA invests in an entity with the intention of engaging in a transaction with a disqualified person on a pre-arranged basis, it is considered prohibited.
Understanding what constitutes a disqualified person and the specific details of the transaction is crucial to determining if a prohibited transaction has occurred under IRC 4975(c)(1)(A).
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Lending of money or extension of credit between an IRA and a disqualified person
Lending money or extending credit between an IRA and a disqualified person is a prohibited transaction under IRC Section 4975(c)(1)(C). This means that an IRA owner cannot lend money or extend credit to themselves or any direct relative, as they are considered "disqualified persons".
However, there is an exemption called the Department of Labor (DOL) Prohibited Transaction Exemption (PTE) 80-26, which allows individuals to lend money to their own IRA in limited circumstances. For example, an individual IRA owner can extend an interest-free, unsecured loan to their IRA for ordinary operating expenses, including payment of benefits. This exemption only applies if no interest or other fees are charged to the plan and if the loan proceeds are used solely for the specified purposes.
Another example of a prohibited transaction is if an IRA owner, who is also a fiduciary, benefits directly or indirectly from the IRA's stock purchase in a capacity other than as a participant. This could include insuring their reelection to a board or improving their position as president of a corporation.
It is important to note that the term "disqualified person" includes not only the IRA owner's fiduciary but also members of their family, such as a spouse, ancestor, lineal descendant, and the spouse of a lineal descendant.
If an IRA owner or their beneficiaries engage in a prohibited transaction, the account ceases to be an IRA as of the first day of that year, and the assets are treated as distributed to the owner at their fair market values. This can result in a taxable gain for the IRA owner.
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Furnishing of goods, services, or facilities between an IRA and a disqualified person
IRC Section 4975(c)(1)(C) states that a prohibited transaction occurs when there is a furnishing of goods, services, or facilities between an IRA and a disqualified person. This means that disqualified persons are prohibited from receiving any goods or services from an IRA. Disqualified persons include the IRA account holder, their spouse, lineal descendants (e.g. children, grandchildren), lineal ascendants (e.g. parents, grandparents), and spouses of those people. It also includes business entities owned 50% or more by these people and certain business partners, directors, and employees in these businesses.
For example, if an IRA purchases a piece of commercial real estate and then allows the IRA account holder or their business to use the property for free, this would be considered a prohibited transaction. Similarly, if an IRA pays a disqualified person, such as the IRA account holder's son, to perform a service like mowing the lawn on the IRA's property, this would also be prohibited.
It is important to note that the law exempts some transactions from being prohibited. For instance, if a disqualified person receives a benefit as a plan participant or beneficiary, such as a participant loan, it is not considered prohibited as long as it is on the same terms as for all other participants and beneficiaries.
The consequences of a prohibited transaction can be significant. If a prohibited transaction occurs, the tax-exempt status of the IRA may be lost, and the IRA's entire value may be treated as taxable to the IRA account holder, possibly with interest and penalties. Therefore, it is crucial to understand and adhere to the rules regarding prohibited transactions to avoid adverse consequences.
While the term "services" in relation to a disqualified person and their real estate investment remains unclear, the Cherwenka case provides some insight. In this case, the court considered whether a self-directed IRA could be exempt from a bankruptcy estate and if the IRA could profit from the sale of distressed real properties. The court agreed that Cherwenka was a disqualified person but held that there was no evidence of a transaction, as there was no exchange of goods or services.
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Transfer of IRA assets to or use by a disqualified person
The Internal Revenue Code (IRC) contains a series of "prohibited transaction" rules intended to prevent the IRA owner from enriching themselves or their family members without actually taking a taxable withdrawal. These rules cause adverse tax consequences for the IRA if it engages in prohibited transactions with any "disqualified person", including the IRA owner themselves and their immediate family members, as well as certain related trusts and business entities.
A disqualified person is prohibited from transferring IRA assets or using them for their benefit. This includes the transfer of plan income or assets to, or use of them by, a disqualified person for their benefit. For example, a disqualified person cannot extend a loan from their IRA to themselves or any direct relative.
The rules also apply to any fiduciary of the account, which includes the IRA owner themselves, and any member of their family, including a spouse, ancestor, lineal descendant, or spouse of a lineal descendant. A disqualified person cannot exercise any discretionary authority or control in managing the IRA or its assets, provide investment advice to the IRA for a fee, or have any discretionary responsibility in administering the IRA.
Some transactions are exempt from being prohibited. For example, if a disqualified person receives any benefit to which they are entitled as a plan participant or beneficiary (such as a participant loan), this is not considered a prohibited transaction, as long as the benefit is on the same terms as for all other participants and beneficiaries.
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Acts by a fiduciary that involve self-dealing
Self-dealing is a form of conflict of interest and an illegal act that can lead to litigation, penalties, and termination of employment for those who commit it. It occurs when a fiduciary acts in their own best interest in a transaction, rather than in the best interest of their clients. Self-dealing may take many forms but generally involves an individual benefiting—or attempting to benefit—from a transaction that is being executed on behalf of another party.
A fiduciary is presumed to act in good faith unless the plaintiff can show otherwise. The plaintiff does not need to prove that they lost money on a certain transaction, but they must show that there was an actual transaction that involved self-dealing. The plaintiff must also show that the fiduciary acted improperly, even if they did not act with intent.
Self-dealing may involve many types of individuals who work under the guidelines of fiduciary responsibility, including trustees, attorneys, corporate officers, board members, and financial advisors, among others. It may consist of a variety of actions seeking to inappropriately enrich oneself, such as:
- Using company funds as a personal loan
- Assuming a deal or opportunity for oneself
- Using insider or non-public information in a stock market transaction
- Advising clients to purchase financial products that are not in their best interest to earn a bigger commission
- Misappropriation or usurpation of corporate assets or opportunities
In the context of IRC Section 4975, a "disqualified person" is prohibited from engaging in certain transactions, such as the furnishing of goods, services, or facilities between a plan and a disqualified person. The term "prohibited transaction" under Section 4975(c) includes any direct or indirect sale, exchange, or leasing of property between a plan and a disqualified person, as well as lending money or extending credit between them.
While the specific case law surrounding IRC Section 4975 and self-dealing was not readily available, the provided sources indicate that self-dealing by a fiduciary is generally considered a breach of fiduciary duty and can result in legal and financial consequences.
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Frequently asked questions
IRC 4975 prohibits any direct or indirect sale or exchange, leasing, or lending of money between an IRA and any "disqualified person". Disqualified persons include the IRA owner, a member of the family, a fiduciary, or a corporation, partnership, trust, or estate where 50% or more of the shares are owned by any of the above.
If a prohibited transaction occurs, there is a penalty tax of 15% of the transaction amount imposed on any disqualified person involved. If the transaction is not corrected within the current tax year, the penalty tax increases to 100% of the transaction amount.
Yes, an exception under IRC Section 4975(d)(17) states that investment advice provided to a retirement account is not subject to the prohibited transaction rules, as long as it is part of an "eligible investment advice arrangement". This means the advisor is either paid a level fee that does not vary based on the investments selected or makes recommendations based on the computer model requirements of IRC Section 4975(f)(8)(C).
